Regulatory Advance and Recovery in the USA and Europe T. Sabri Öncü Center for Advanced Financial Research and Learning

Sabotage Sabotage, “the strategy of delay, restriction, hindrance and defeat”, “has to do with something in the nature of vested right” and “of vested interest.” “So long as the system remains unchanged”, sabotage is a “necessary and legitimate part of it.” Veblen (1921) “We make profits, not steel.” Edgar B. Speer (1973) CEO, US Steel,

Sabotage to Loot “Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.” Akerlof and Romer (1993) “I would do anything to make money.” Bernard (1997) 3

Important Ongoing Regulatory Debates I. What is “systemic risk”? – How should we contain systemic risk when it arises? II. Will systemic risk simply move to “shadow banks”? – How should we regulate “shadow banking”? 4

What is “systemic risk”? (I) – Micro-prudential view: Contagion Failure of an entity leads to distress or failures of others – Too-big-to-fail institutions Regulate TBTF better – Systemically Important Financial Institutions (SIFIs) Regulate SIFIs better 5

What is “systemic risk”? (II) – Macro-prudential view: (Diamond-Dybvig Shleifer-Vishny 1992) Common factor exposures Runs – Several entities fail together as Short-term creditors demand immediacy Against long-term assets But the system has limited capacity (capital?) to provide immediacy – The micro-prudential and macro-prudential views are not necessarily mutually exclusive 6

What is “systemic risk”? (III) Acharya and I (2010) defined systemic risk: “broadly as the expected losses from the risk that the failure of a significant part of the financial sector leads to a reduction in credit availability with the potential for adversely affecting the real economy.” 7

What is Shadow Banking? 2007/McCulley: Shadow banking is the whole alphabet soup of levered up nonbank investment conduits, vehicles, and structures. 2010/Acharya and Öncü: A shadow bank is a nonbank financial institution that behaves like a bank, borrows short-term in rollover debt markets, leverages itself significantly, and lends and invests in longer-term in illiquid assets. Unlike banks, however, the shadow banks are much less regulated. 2010/Adrian et al: Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees. 2012/Ghosh et al: Shadow banking comprises a set of activities, markets, contracts, and institutions that operate partially (or fully) outside the traditional commercial banking sector, and, as such, are either lightly regulated or not regulated at all. The distinguishing feature of shadow banking is that it decomposes the process of credit intermediation into a sequence of discrete operations.. A shadow banking system can be composed of a single entity that intermediates between end-suppliers and end-borrowers of funds, or it could involve multiple entities forming a chain. 8

What is Shadow Banking? Key points :  Any shadow banking system conducts maturity, credit and liquidity transformation outside the traditional banking system. Thus, not only it is less regulated than the traditional banking system or not regulated at all, but also there is no explicit access to central bank liquidity or public sector credit guarantees.  Since any shadow banking system decomposes the process of credit intermediation into a sequence of discrete operations, it can be a collection not only of single financial entities acting independently, but also of (and usually is) networks of multiple financial entities acting together or both: banks, formal and informal nonbank financial institutions, and even credit rating agencies, regulators and governments.  Any shadow banking system is highly levered. Further, while its assets are risky and illiquid, its liabilities are prone to “bank runs”. 9

Normal versus Fat-tailed Distributions Tail Risk 10

Manufacturing Tail Risk Sabotage to Loot Depository Institutions Deregulation and Monetary Control Act (1980) introduced two classes of capital: primary (core) and secondary (fictitious) Basel I (1988 – 1992) introduced risk weighted assets – bank assets were classified into five risk categories, carrying risk weights of zero, ten, twenty, fifty, and one hundred percent (credit default swaps were a response of the financial sector); reintroduced two classes of capital: tier 1/primary (core) and tier 2/secondary (fictitious) Financial Services Modernization Act (1999) removed barriers among banking companies, securities companies and insurance companies that prohibited any one institution from acting as any combination of an investment bank, a commercial bank, and an insurance company Commodity Futures Modernization Act (2000) ensured deregulation of the over-the-counter (OTC) derivatives Bankruptcy Abuse Prevention and Consumer Protection Act (2005) “safe harbor” treatment in bankruptcy extended to forward contracts, commodity contracts, repurchase agreements and securities contracts 11

Manufacturing Tail Risk IMF Global Financial Stability Report

Manufacturing Tail Risk Growth of the Over-the-Counter Derivatives 13

Manufacturing Tail Risk Consumer Debt Growth 14

AssetsLiabilities LoansDeposits Capital Bank Balance Sheet Manufacturing Tail Risk When Banking was Boring 15

AssetsLiabilities Loans Deposits Capital Bank Balance Sheet AssetsLiabilities LoansEquity (Asset-Backed Securities) Special Purpose Vehicle Manufacturing Tail Risk When Banking was Still Boring: Securitization 16

AssetsLiabilities Deposits Capital Bank Balance Sheet AssetsLiabilities Debt (Asset-Backed Commercial Paper) Conduit Guarantees Loans Manufacturing Tail Risk Banking gets Exciting – First Kind 17

AssetsLiabilities Loans Deposits Capital Bank Balance Sheet AssetsLiabilities LoansAsset-Backed Securities Special Purpose Vehicle Manufacturing Tail Risk Banking gets Exciting – Second Kind Credit Rating Agencies AAA BB NR 18

AssetsLiabilities Loans Deposits Capital Bank Balance Sheet AssetsLiabilities LoansAsset-Backed Securities Special Purpose Vehicle Manufacturing Tail Risk Banking gets Exciting – Third Kind Credit Default Swaps + Guarantees Fannie Mae - Freddy Mac AIG Bond Insurers 19

Is Reregulating Finance the Solution? “So long as the system remains unchanged”, sabotage is a “necessary and legitimate part of it.” Veblen (1921) 20

Regulatory Advance in the US and Europe (I)  Parties involved in the US: Congress, Senate, Fed, FDIC, CFTC, etc.  What is on the table is the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010  Progress: Very slow. Wall Street and Banking Lobby are at work to slow down the process.  Parties involved in Europe: European Parliament, European Commission, European Central Bank, domestic governments and regulators, etc.  What is on the table is the new EU Financial Regulation (FR), adopted by the Commission in October 2012 and published December  Progress: Very slow. Banking Lobby and Angela Merkel are at work to slow down the process. 21

Regulatory Advance in the US and Europe (II) What advance? 22

Recovery in the US and Europe (II) What recovery? 23